The Reports Consolidation Act of 2000[1]
requires that the Treasury Inspector General for Tax Administration (TIGTA)
summarize, for inclusion in the Department
of the Treasury Accountability Report for Fiscal Year 2007, its perspective
of the most serious management and performance challenges confronting the
Internal Revenue Service (IRS or Service).The top 10 challenges in order of priority are:

Modernization;

Tax
Compliance Initiatives;

Security;

Providing
Quality Taxpayer Service Operations;

Complexity
of the Tax Law;

Human
Capital;

Erroneous
and Improper Payments;

Taxpayer
Protection and Rights;

Processing
Returns and Implementing Tax Law Changes During the Tax Filing Season; and

Using
Performance and Financial Information for Program and Budget Decisions.

TIGTA’s assessment of the major IRS
management challenge areas for Fiscal Year 2008 has not changed substantially
from the prior year.While the IRS has
continued to address each challenge area, TIGTA was unable to remove any
challenge areas at this time.However, TIGTA
did make one important change to the priority of the challenges.Human Capital
moved from last place to sixth in terms of importance in our view and Using Performance and
Financial Information for Program and Budget Decisions moved from sixth place to tenth.

One
reason for this change is last year, the Office of Personnel Management
reported that approximately 60 percent of the Federal Government’s 1.6 million
white-collar employees and 90 percent of about 6,000 Federal executives will be
eligible for retirement over the next 10 years.Along with a retiring workforce, the IRS faces gaps in talent because of
changes in the knowledge, skills, and competencies in occupations needed to
meet its mission.The IRS needs to
strengthen its efforts and use of available flexibilities to acquire, develop,
motivate, and retain talent. Strategic
human capital management must be the centerpiece of the IRS’s change management
strategy.

The Business
Systems Modernization (Modernization) program is a complex effort to modernize
IRS technology and related business processes.It involves integrating thousands of hardware and software components
while replacing outdated technology and maintaining the current tax system.

The
Modernization program is in its ninth year and has received approximately $2.3
billion for contractor services.Additionally, the IRS had spent $220 million through Fiscal Year 2006
and planned to spend an additional $45 million in Fiscal Year 2007 to manage
the Modernization program.According to
the IRS’s original plan, the Modernization program should be near the halfway
point in Calendar Year 2007.However,
due to receiving less funding than initially anticipated and having
difficulties in managing contractor work, the IRS has not completed as many
Modernization projects as planned.For
example, the Customer Account Data Engine is the foundation of the
Modernization program.The IRS
originally planned to complete replacement of its Individual Master File with
the Customer Account Data Engine in 2005.[2]The current
estimated completion date for this replacement is 2012.

Although the
IRS has made advances in its Modernization effort, it has not maintained
anticipated progress.TIGTA has previously
reported that inconsistent compliance with project development controls has
contributed to delays in project deliveries, increased development costs, and
reduced capabilities.[3]Since Fiscal Year
2002, TIGTA’s Modernization program annual assessments have cited the following
four specific challenges the IRS needs to overcome to deliver a successful
modernization effort:

Manage the increasing complexity and risks of the
Modernization program;

Maintain the continuity and strategic direction with
experienced leadership; and

Ensure that
contractor performance and accountability are effectively managed.

These
challenges continue to exist.

Accordingly, since solutions to the IRS’s serious and intractable
financial management problems largely depend upon the success of the IRS’s
Modernization efforts, in January 2005 the financial management risk was
combined with the Modernization risk into the Business Systems Modernization high-risk
area.[4]Modernization remains a high risk for the
IRS.

Tax Compliance Initiatives

A
similarly compelling challenge confronting the IRS is tax compliance.Tax compliance initiatives include the administration of tax
regulations, collection of the correct amount of tax for businesses and
individuals, and oversight of tax-exempt and government entities.Late in
Fiscal Year 2007, the Department of the Treasury (Department) issued a report
on improving voluntary compliance.[5]The report outlines
steps that the IRS plans to take to increase voluntary compliance and reduce
the tax gap.

Business and Individual

The IRS defines the gross
tax gap as the difference between the estimated amount taxpayers owe and the
amount they voluntarily and timely pay for a tax year. The IRS estimated that the
gross tax gap for Tax Year 2001 was $345 billion.TIGTA evaluated the reliability of the
IRS-developed tax gap figures and concluded that the IRS still does not have
sufficient information to completely and accurately assess the overall tax gap
and voluntary compliance rate.[6]The IRS has significant challenges in both
obtaining complete and timely data, and developing the methods for interpreting
the data.Although better
data will help the IRS further identify noncompliant segments of the
population, broader strategies and better research are also needed to determine
what actions are most effective in addressing noncompliance.

The IRS must continue to seek accurate measures
of the various components of the tax gap and the effectiveness of actions taken
to reduce it.This information is
critical to the IRS for strategic direction, budgeting, and staff
allocation.Additionally, the
IRS Oversight Board has adopted an 86 percent voluntary compliance goal by 2009,
and Senate Finance Committee Chairman Max Baucus has asked for a 90 percent
voluntary compliance goal by 2017.

As
the IRS takes steps to improve compliance, TIGTA’s reviews will help gauge the
IRS’s progress in achieving the specific long-term compliance objectives. The
Department also needs these measures for tax policy purposes, and Congress
needs this information to help develop legislation that improves the
effectiveness of the tax system.For
example, the IRS may never significantly reduce the number of miscellaneous
income and wage statements with mismatched names and identification numbers
without legislative changes.TIGTA reports
and those of the Government Accountability Office (GAO) have long called for
legislative changes to address fundamental and systemic problems associated
with inaccurate identification numbers on miscellaneous income and wage
statements.In a recent review, TIGTA
was successful in manually matching 50 percent of the sampled information
documents containing incorrect names and identification numbers to taxpayer
accounts.[7]Based on that
sample, TIGTA projected that approximately 6,000 individuals had not filed tax
returns, although the statements reported they had earned, on average, about
$104,000.

Tax-Exempt Entities

The IRS continues to face challenges in
administering programs focused on tax-exempt organizations to ensure that they
comply with applicable laws and regulations to qualify for tax-exempt status. The IRS has noted that the nonprofit
community has not been immune from the recent trends toward bad corporate
practices that have been highlighted in the for-profit area.[8]Recent concerns involve a highly noncompliant credit counseling
industry, differentiating tax-exempt
hospitals from for-profit hospitals, and seemingly excessive compensation and
loans to executives of charitable organizations.

TIGTA has made
recommendations that would improve the IRS’s oversight of filing compliance by
political entities and State and local governments, enhance its ability to
identify and address abusive tax-avoidance transactions within the tax-exempt
sector, and identify potential terrorist activities related to tax-exempt
organizations.Furthermore, TIGTA
recommended additional improvements to assure that timely, accurate, and
complete information returns are received for employee benefit plans and that referrals
of noncompliance are examined timely.We
also noted that the IRS must develop better research tools, improve training to
trace funds through complex transactions, and develop the ability to analyze
data to determine high-risk noncompliant areas. The IRS agreed with TIGTA’s
recommendations and initiated corrective actions to address these concerns.

Security of the Internal Revenue Service

Millions
of taxpayers entrust the IRS with sensitive financial, personal and other data that
are processed by and stored on IRS computer systems.Reports of identity thefts from both the
private and public sectors have heightened awareness of the need to protect
this data.The risk that sensitive data
or computer systems could be compromised and computer operations disrupted
continues to increase.These vulnerabilities
are due to internal factors, such as the increased connectivity of computer
systems and increased use of portable laptop computers; and external factors,
such as the volatile threat environment resulting from increased terrorist and
hacker activity.The IRS has designated
computer security as a material weakness under the Federal Managers’ Financial
Integrity Act of 1982.[9]

Section
301 of the Federal Information
Security Management Act (FISMA)[10]
requires each Federal agency to report annually to the Office of Management and
Budget and Congress on the effectiveness of its security programs and to perform
an annual independent evaluation of its information security program and
practices.During
2007, the IRS Modernization and Information Technology Services organization
and representatives from each IRS operating unit have partnered to improve the
IRS’s compliance with FISMA.Efforts
continued this year to develop an enterprise-wide approach to help employees
understand their responsibilities for securing IRS systems and data.

The IRS has
made steady progress in complying with FISMA requirements since the law’s enactment
in 2002 and states it continues to place a high priority on efforts to improve
its security program.However, the
Service still needs to do more to adequately secure its systems and data.The most significant areas of concern are
annual testing of security controls and contingency plans, implementation of
configuration management standards,[11]
and privacy requirements for protecting personally identifiable information.Additionally,
phishing schemes are a growing security concern.[12]In Fiscal Year 2006, TIGTA worked closely
with the IRS to create a joint IRS-TIGTA reporting site.By September 30, 2007, approximately 18,700 complaints had
been received and 435 different phishing schemes had been identified.TIGTA’s FISMA
evaluations and other audits led to the conclusion that
sufficient attention is not yet being given by the IRS to the security of
sensitive systems.

Providing Quality Taxpayer
Service Operations

Since the late 1990s, the IRS has increased its delivery of quality
customer service to taxpayers. The first
goal in the IRS’s current strategic plan is to improve taxpayer service. However, since the late 1990s, the IRS has
allocated over time more resources to its collection, examination, and criminal
investigation functions and fewer resources to taxpayer service functions. As a result of this resource shift and other
factors, in July 2005,
Congress requested that the IRS develop a five-year plan, including an outline
of which services the IRS should provide and how it will improve services for
taxpayers. The IRS developed the plan,
the Taxpayer Assistance Blueprint, in two phases.

The focus of the Blueprint is on
services that support the needs of individual filers who file or should file the
Form 1040 series tax returns.[13]The plan states that the initiative will
address the challenges of effectively and efficiently aligning service content,
delivery, and resources with taxpayer and partner expectations.[14]The Phase I report
identified strategic improvement themes by researching IRS services relative to
taxpayers’ needs and preferences.The Phase
II report was designed to validate those themes through further research of
taxpayers’ service preferences and to create the strategic plan for service delivery.

The IRS is already facing challenges
with its Blueprint.For the Phase I
report, the conclusions and strategic improvement
themes were valid; however, not all information was accurate or
consistent.Given the importance of this
plan as the IRS moves forward, inaccuracies and inconsistencies will put the
plan at risk of improperly aligning service content, delivery, and resources
with taxpayer and partner expectations.

Complexity
of the Tax Law

Simplicity, transparency,
and ease of administration are interrelated and desirable features of a tax
system. Over
the years, the Federal tax system, especially the Federal income tax, has become
more complex, less transparent, and subject to frequent revision. Tax complexity and frequent revisions to the
Internal Revenue Code make it more difficult and costly for taxpayers who want
to comply with the system’s requirements and for the IRS to explain and enforce
the tax laws. Tax law complexity results
in higher costs for both tax administration and tax compliance.Simplification and reform have
the potential of reducing the tax gap by billions of dollars.

Tax law complexity continues to challenge the IRS and
taxpayers. For example, TIGTA recently
determined that the IRS regulations for like-kind exchanges are complex and
may be unclear to taxpayers.[15]Little published information exists regarding
the IRS’s position on like-kind exchanges involving second and vacation homes.This absence of clarification leaves
unrebutted the sales pitch of like-kind exchange promoters who may encourage
taxpayers to improperly claim deferral of capital gains through “tax-free”
exchanges.[16]These complexities hamper IRS efforts to provide assistance to taxpayers.Without meaningful simplification, the
complexities of the current tax code will likely continue to contribute to the
tax gap.

Human Capital

The Government Performance
and Results Act of 1993[17]
was enacted to bring more accountability to Federal agencies for how they spent
their budget and how well they fulfilled their public service roles.In 2001, the President’s Management Agenda
designated Strategic Management of Human Capital as the first of its five governmentwide
initiatives.Despite significant focus
and progress over the past few years, the GAO has designated human capital as a
“high risk” governmentwide concern and recently reported that ample
opportunities exist for agencies to improve.The GAO also reported that a governmentwide framework to advance human
capital reform is needed.[18]

The Federal workforce is aging, and
agencies are dealing not only with retirements and staff turnover, but also
with the unique challenges of the 21st Century.The IRS recognizes that it must be prepared
to respond to an increasing and more demanding population, a more global and
multi-lingual environment, and an increasing number of taxpayers who have
complex financial holdings and the means and motive to resist paying their
taxes.[19]In addition, the IRS, along with other
Federal agencies, is slowly moving toward changing pay, classification, and
performance management systems to transition to a more market-based and
performance-oriented culture.While the
IRS has made some progress in these areas, the strategic management of human
capital remains one of the IRS’s major management challenges.

TIGTA has
conducted audits in areas such as recruiting, workforce planning, training
delivery, and employee turnover.As a
result of these audits, we have made a significant number of recommendations
for improvement.The IRS has agreed with
these recommendations and stated it plans to take corrective actions.In 2008, TIGTA will begin executing a broad strategy for assessing human capital
initiatives at an IRS agency-wide level and will focus on key portions of the
IRS’s Human Capital strategy.

Erroneous and Improper Payments

As defined by the Improper
Payments Information Act of 2002,[20] an
improper payment is any payment that
should not have been made or that was made in an incorrect amount (including
overpayments and underpayments) under statutory, contractual, administrative,
or other legally applicable requirements.It includes any payment to an ineligible recipient, any payment for an
ineligible service, any duplicate payment, payments for services not received,
and any payment that does not account for credit for applicable discounts.For the IRS, improper and erroneous payments
generally involve improperly paid refunds, tax return filing fraud, or
overpayments to vendors or contractors.Some tax credits, such as the Earned
Income Tax Credit and the Education Credit, provide opportunities for abuse in
income tax claims.The IRS estimated that between 27 percent and 32
percent of the $31 billion in Earned Income Tax Credits claimed on TY 1999 returns should not have been paid.[21]The IRS’s Criminal Investigation function is responsible for
detecting and combating tax refund fraud through its Questionable Refund
Program, which was established to
address the serious problem of refund fraud, now estimated to exceed $1 billion
annually.On September 29, 2006, the Criminal Investigation function reported that
during Processing Year 2006, it had identified more than 44,700 fraudulent
refund returns claiming approximately $232.3 million in refunds during
Processing Year 2006.In contrast, through
September 13, 2007, the Criminal Investigation function identified approximately
200,900 fraudulent returns claiming about $1.3 billion in refunds during
Processing Year 2007.

Although the IRS has taken actions to
improve the Questionable Refund Program, TIGTA continues to have concerns with many of the procedures that have
been implemented.For example, in
January 2006 the National Taxpayer Advocate reported that automatically preventing
a future year’s tax return refund was a significant problem with the
Questionable Refund Program.[22]According to the National Taxpayer Advocate, future refunds were being
frozen until taxpayers filed a certain number of legitimate returns even though there was
little evidence to suggest that taxpayers were likely to repeat refund fraud
after the initial attempts.As a result,
the IRS Office of Refund Crimes discontinued placing a freeze on future years’
refund returns and instead identified certain high-risk categories as
exceptions to this process.This revised
procedure concerns us because we believe the future year freeze is an effective
means for protecting revenue, when considered
along with the procedural changes to notify taxpayers of refund freezes.

The
IRS continues to dedicate significant resources and attention toward
implementing the taxpayer rights provisions of the Internal
Revenue Service Restructuring and Reform Act of 1998 (RRA 98).[23]Annual audit
reports are mandated for the following taxpayer-rights provisions:

Notice of
Levy

Restrictions on the Use of Enforcement Statistics to Evaluate
Employees

In general, the IRS has improved its compliance with these
statutory taxpayer rights provisions.For example, TIGTA believes the IRS’s efforts to ensure that managers are
not using enforcement statistics, production goals or quotas to evaluate
employees are generally effective and are helping protect the rights of
taxpayers.Nonetheless, there is still
room for improvement with respect to certain provisions.TIGTA continues to identify instances in
which there is no documentation that taxpayers were advised of their rights when
agreeing to extend the period of time the IRS has to assess taxes. TIGTA also continues to identify instances in
which IRS employees refer to taxpayers as Illegal Tax Protesters or similar
designations.

Each filing season tests the IRS’s ability to
implement tax law changes made by Congress. It is during the filing season that most
individuals file their income tax returns and call the IRS with questions about
specific tax laws or filing procedures.Correctly implementing tax law changes is a continuing challenge because
the IRS must identify the tax law changes; revise thevarious tax forms, instructions, and publications; and reprogram the
computer systems used for processing returns.Changes to the tax laws have a major effect on how the IRS conducts its
activities, what resources are required, and how much progress can be made on
strategic goals.Congress frequently changes
the tax laws; thus, some level of change is a normal part of the IRS
environment. However, certain types of
changes can significantly impact the IRS in terms of its quality and
effectiveness of service and in how taxpayers perceive the Service.For example, the 2007 Filing Season
was successful but demanding for the IRS.Before the filing season began, the IRS Commissioner told Congress that the
IRS was at high risk due to high-profile administrative changes such as the
Telephone Excise Tax Refund and the Split Refund option.Late enactment of the Tax Relief and Health
Care Act of 2006[25]
added additional risk to the 2007 Filing Season.

Potential changes to the Alternative Minimum Tax
(AMT) may pose a significant challenge for the IRS for the 2008 Filing
Season.The AMT originally was
created as a parallel tax system in 1969 to prevent 155 wealthy people from
avoiding taxes through excessive exemptions, credits and other deductions. Because it was not indexed for inflation, the AMT
increasingly affects people with more modest incomes by denying deductions such
as personal exemptions, property taxes and medical expenses.

Unless
Congress acts, the AMT will gradually impose $1.35 trillion in additional taxes
on U.S.
households over the next decade, including as many as 23 million families for
Tax Year 2007. A series of temporary
measures that index the AMT for inflation have limited the tax's reach to about
4 million households annually.Lawmakers
have not yet renewed the temporary fix for Tax Year 2007.A delay in legislation renewing the temporary
fix could significantly disrupt the tax filing season because the IRS would
need time to print new tax forms and reprogram computers.

Using Performance and Financial Information for Program and
Budget Decisions

While the IRS has made some progress in
using performance and financial information for program and budget decisions,
this area is still a major challenge.The IRS lacks a comprehensive, integrated system that provides accurate,
relevant, and timely financial and operating data that describes performance
measures, productivity, and associated costs of IRS programs.In addition, the IRS cannot produce timely,
accurate, and useful information needed for day-to-day decisions, which inhibits
its ability to address financial management and operational issues in order to
fulfill its responsibilities.TIGTA has
continued to report that various IRS management information systems are
insufficient to enable IRS management to measure costs, determine if
performance goals have been achieved, or monitor progress in achieving program
goals.For example, TIGTA reported that progress is being made in addressing the reliability
of Trust Fund Recovery Penalty (TFRP) transaction information recorded in taxpayer
accounts (a long-term material weakness); however significant work
remains.Specifically, as of May 2007, there
were nearly 50,000 TFRP-related errors in taxpayers’ accounts that the IRS needs
to correct before implementing the systemic posting of payments on TFRP
assessments beginning in March 2008.[26]

Conclusion

These are the 10 major IRS management
challenges issues for the IRS in Fiscal Year 2008.TIGTA’s FY 2008 Annual Audit Plan contains our
planned audits, inspections, and evaluations and is organized by these challenges.If you have questions or wish to discuss TIGTA’s
views on these management and performance challenges in greater detail, please
contact me at (202) 622-6500.

[4] In January
2005, the Government Accountability Office (GAO) combined its two previous
high-risk areas, IRS Business Systems Modernization and IRS Financial
Management, into one Business Systems Modernization high-risk area.See U.S. Gov’t Accountability Office,
GAO-05-207, High Risk Series:An Update (2005).

[6]
Treasury Inspector General for Tax Administration, Ref. No. 2006-50-077, Some Concerns Remain About the Overall
Confidence That Can Be Placed in Internal Revenue Service Tax Gap Projections
(2006).

[8]Written
Statement of Mark W. Everson, Commissioner of Internal Revenue, Before the
Committee on Finance, United States Senate Hearing on Exempt
Organizations: Enforcement Problems, Accomplishments, and Future Direction, April
5, 2005.

[9]31 U.S.C. §§ 1105, 1106, 1108, 1113, 3512 (2000).The Federal Managers’ Financial Integrity
Act (FMFIA) requires that agency management establish and maintain effective
internal controls to achieve the objectives of: 1) effective and efficient operations; 2)
reliable financial reporting; and 3) compliance with applicable laws and
regulations.The FMFIA also requires the
head of each Executive agency to report annually to the President and the
Congress on the effectiveness of the internal controls and any identified
material weaknesses in those controls.Reporting material weaknesses under FMFIA is not limited to weaknesses
over financial reporting.

[11]Configuration
management is a collection of processes and tools that promote network
consistency, track network change, and provide up-to-date network documentation
and visibility. By building and
maintaining configuration management standards, several benefits may be achieved,
such as increased security, improved network availability and lower costs.

[12] Phishing is
the act of sending an email to a user falsely claiming to be an established
legitimate enterprise in an attempt to scam the user into surrendering private
information that could be used for identity theft.

[13]The Form
1040 series tax returns include any IRS tax forms that begin with “1040” such
as the U.S. Individual Income Tax Return (Form 1040), U.S. Individual Income
Tax Return (Form 1040-A), and Income Tax Return for Single and Joint Filers
With No Dependents (Form 1040EZ).

[15]A like-kind exchange is also known as
a “1031 exchange,” referring to Section 1031 of the Internal Revenue Code. In essence, a like-kind exchange is a way of
deferring capital gains taxes by reinvesting proceeds from a sale into a
similar asset.

[26]Treasury Inspector General for Tax
Administration, Ref. No. 2007-10-183, Progress Has Been Made in Improvingthe Accuracy of Trust Fund RecoveryPenalty Transactions; However,Significant Work
Remains (2007).